After years of reluctance, did the European Central Bank finally announce a quantitative easing program on Thursday? That depends on your definition of QE, which must rank as one of the most vaguely-defined terms in economics.
What is QE?
It isn’t just a central bank buying bonds. For example, the Federal Reserve in normal, noncrisis times buys and sells short-term U.S. government debt to set interest rates. It was only after the crisis hit in 2008 that the Fed started to buy significant amounts of other stuff: first, $600 billion of mortgage-backed securities and debt issued by the U.S. government-controlled mortgage companies Fannie Mae and Freddie Mac; later on, hundreds of billions of longer-term U.S. government debt and other assets. With short-term rates basically at zero, the Fed needed some other tool to boost the economy. Buying a broader range of assets other than short-term government debt should help drive down interest rates across the economy, bankers and economists believe.
Yet former Fed Chairman Ben Bernanke in 2009 said that what the bank was doing didn’t count as “pure” quantitative easing. “Our approach—which could be described as ‘credit easing’—resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental.”
Mr. Bernanke seemed to be splitting hairs. Here’s a rough definition: QE is when a central bank buys a quantity of assets other than short-term government debt to set monetary policy.
What did the ECB do?
The ECB said it would buy a broad range of assets, including assets backed by small business loans and residential mortgages; the moves are supposed to juice growth and prop up inflation, which is running at dangerously low levels in the euro zone. Mr. Draghi also left the door open for buying sovereign and other debt issued by government entities. The measures, he said, are aimed at moving the ECB’s balance sheet towards its size at the beginning of 2012, around €2.7 trillion ($3.5 trillion). The balance sheet now stands at €2 trillion.
This is a significant departure for the ECB. Unlike the Fed, it doesn’t control interest rates by buying or selling government debt. Instead, it lends to banks at a specific interest rate against collateral provided by the banks. Only rarely does it buy assets as part of its monetary policy operations. Shortly after the crisis in 2008, it announced a small program of covered bond purchases, totaling just €60 billion. It also bought euro-zone government bonds during the height of the debt crisis to prevent the euro zone from blowing apart.
Is the ECB’s program QE?
Here is what Mr. Draghi said: “The definition of QE is not really related to its size but rather to its modalities. QE is an outright purchase of assets… rather than accepting these assets as collateral for lending. The ECB would outright purchase these assets. It would inject money into the system.”
The ECB program announced on Thursday sounds a lot like QE.
Why Use QE?
The ECB’s main target for the program is to boost its balance sheet to its size at the beginning of 2012. So why use asset purchases rather than other methods, such as the long-term lending operations that the bank had previously used to boost its balance sheet to €3 trillion by March 2012? The answer, says Royal Bank of Scotland economist Richard Barwell, is control. The ECB would depend on banks to actually use the long-term lending programs. If they don’t, then the ECB might not hit its balance-sheet expansion target.
“Before, the balance sheet got big because the banks wanted cash, because the world was falling apart,” Mr. Barwell said. Now that financial stress in the euro zone is lower and banks aren’t starved for liquidity, they might not borrow from the ECB to drive up its balance sheet.
If the ECB actually buys assets, it can be assured of hitting its balance-sheet expansion target, without relying on needy banks.